Principles of Managerial Finance

1. Chapter One
Overview of Managerial Finance
Principles of Managerial Finance
First Canadian Edition
Lawrence J. Gitman and Sean Hennessey
© 2004 Pearson
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2. Learning Goals
LG1 – Define finance and describe its three
major areas and career opportunities.
LG2 – Review basic forms of business
organization, their strengths and
weaknesses.
LG3 – Describe managerial finance function and
differentiate from economics and
accounting.
© 2004 Pearson
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3. Learning Goals (continued)
LG4 – Identify key activities of financial
manager within the firm.
LG5 – Explain why wealth maximization is
firm’s goal.
LG6 – Explain how EVA, stakeholder focus,
and ethical behaviour relate to firm’s
goal.
LG7 – Discuss agency issue as it relates to
owner wealth maximization.
© 2004 Pearson
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4. What is Finance?
• At the macro level, finance is the study of financial
institutions and financial markets and how they operate
within the financial system in both the Canadian and
global economies.
• At the micro level, finance is the study of financial
planning, asset management, and fund raising for
businesses and financial institutions.
• Financial management can be described in brief using
the following balance sheet.
© 2004 Pearson
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5. What is Finance?
Assets: Liabilities & Equity:
Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Less: Accumulated dep. Common Stock
Goodw ill Paid-in-capital
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
Working
Capital Working
© 2004 Pearson
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Capital
Investment
Decisions Financing
Decisions
Macro Finance

6. What is Finance?
• A well-developed financial system is a hallmark and
essential characteristic of any modern developed
nation.
• Financial markets, financial intermediaries, and
financial management are the important components.
• Financial markets and financial intermediaries
facilitate the flow of funds from borrowers to savers.
• Financial management involves the efficient use of
financial resources in the production of goods.
© 2004 Pearson
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7. Areas of Specialization in Finance
• Financial Markets
– Markets of users and savers of funds.
• Financial Services
– Design and delivery of financial advice and
products to individuals, businesses, government.
• Managerial Finance
– Financial management of business firms.
© 2004 Pearson
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8. Areas of Employment in Finance
• Financial Analyst
• Capital budgeting analyst/manager
• Project finance manager
• Cash manager
• Credit analyst/manager
• Pension fund manager
© 2004 Pearson
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9. Basic Forms of Business
Organization
• Sole Proprietorship
– Owned by one person, operated for personal profit.
• Partnerships
– Owned by two or more people, operated for joint
profit.
• Corporations
– “Legal entity”, owned by individuals, operated for
joint profit.
© 2004 Pearson
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10. Sole Proprietorship
STRENGTHS:
• Low organizational cost
• Income taxed once as
personal income
• Independence
• Secrecy
• Ease of dissolution
WEAKNESSES:
• Unlimited liability
• Limited funding
• Proprietor must be all
• Difficult to develop staff
career opportunities
• Lack of continuity on
death of proprietor
© 2004 Pearson
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11. Partnerships
STRENGTHS:
• Improved funding
sources
• Increased managerial
talent
• Income split by
partnership contract,
taxed as personal
income
WEAKNESSES:
• Unlimited liability to
all partners
• Partnership dissolved
upon death of partner
• Difficult to liquidate
or transfer ownership
© 2004 Pearson
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12. Corporations
STRENGTHS:
• Owners’ liability limited
• Large capitalization
possible, greater funding
• Ownership readily
transferable
• Indefinite life
• Professional management
WEAKNESSES:
• Higher tax rates
• Expensive organization
• Greater government
regulation
• When publicly traded,
lacks secrecy
© 2004 Pearson
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13. Corporate Organization Chart
© 2004 Pearson
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14. Organization of Finance Functions
• CFO – Chief Financial Officer
• Treasurer responsibilities:
– Financial planning, fund raising, capital
expenditure decisions, cash and credit
management.
• Controller responsibilities:
– Corporate accounting, cost accounting, and tax
management.
© 2004 Pearson
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15. Relationship to Economics
Fundamental Economic Principle:
• Marginal Analysis
– Financial decisions should be made and actions
taken only when the added benefits exceed the
added costs.
© 2004 Pearson
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16. Relationship to Accounting
• Cash Flows
– Accrual Basis: recognizes sales revenue and
expenses incurred to make sale at time of sale.
– Cash Basis: recognizes revenues and expenses
as they occur.
© 2004 Pearson
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17. Accounting vs. Financial Views
Accounting View
(Accrual Basis)
Income Statement
Peakes Quay, Inc.
For year ended 12/31
Financial View
(Cash Basis)
Cash Flow Statement
Peakes Quay, Inc.
For year ended 12/31
Sales revenue $100,000
Less: Costs 80,000
Net Profit $ 20,000
Cash inflow $ 0
Less: Cash outflow 80,000
Net cash flow ($80,000)
© 2004 Pearson
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18. Financial Manager–Key Activities
Financial Analysis & Planning
Balance Sheet
Current
Assets
_______________
Fixed
Assets
Current
Liabilities
_______________
Long-Term Funds
(Debt & Equity)
Making
Investment
Decisions
Making
Financing
Decisions
© 2004 Pearson
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19. Should Firms Maximize Profit?
• Corporations commonly define profit as
“Earnings per Share” (EPS).
– A measure of total earnings divided by total
number of ownership shares.
• EPS ignores critical factors of
– the timing of the returns.
– cash flows available to common shareholders.
– risk factors facing the firm.
© 2004 Pearson
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20. Or Should Firms Maximize
Shareholder Wealth?
• Evaluating Shareholder Wealth addresses
factors of timing, cash flows and risk
ignored by the EPS.
• Therefore, Maximizing Shareholder Wealth
is a more comprehensive goal for the firm,
its managers and employees.
• This can be explored through “economic
valued added” and a focus on stakeholders.
© 2004 Pearson
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21. Economic Value Added – EVA®
• EVA measures whether an investment
contributes to shareholder wealth.
• EVA is calculated by subtracting cost of
funds used from after-tax operating profits.
• While popular, EVA is essentially derived
from the concept of “net present value.”
© 2004 Pearson
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22. What about Stakeholders?
• Stakeholders include groups that have direct
economic links to the firm.
• Stakeholders include not only owners, but
also employees, customers, suppliers, and
creditors.
• Maintaining positive stakeholder
relationships helps maximize long-term
benefits to shareholders.
© 2004 Pearson
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23. Importance of Ethics
The standards of conduct or moral judgment:
• Honesty, trustworthiness, fair dealing are
foundations of sustainable business relations:
– With customers,
– With suppliers,
– With creditors,
– With employees,
– With owners.
• Ethical behaviour is necessary to achieve the goal
of maximizing shareholder wealth.
© 2004 Pearson
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24. Internal Ethical Review
• Are rights of stakeholders being violated?
• Does firm have extra duties to stakeholders?
• Will a decision unfairly discriminate benefits
among stakeholders?
• If stakeholders are harmed, should this be
remedied? How?
• What is the relationship between shareholders
and stakeholders?
© 2004 Pearson
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25. Financial Goals of a Company
• Maximize sales.
• Maximize cash flow.
• Maximize market
share.
• Maximize profit.
• Minimize costs.
• Maximize return on
sales, investment,
equity.
• Ensure earnings
stability.
• Achieve target goals
for sales, profits,
market share or return.
© 2004 Pearson
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26. Agency Issues:
The Principal-Agent Problem
• Whenever ownership is independent of
management there exists potential problem of
conflicts.
• The owner’s goals for the firm are best described
as maximizing shareholder wealth.
• Managers are also concerned with personal
wealth, job security, lifestyle, and benefits. These
concerns may conflict with shareholder interests.
© 2004 Pearson
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27. Resolving the Agency Problem
• Good corporate governance by the Board of
Directors is the heart of any resolution.
• Agency Costs – the costs of this governance:
– Monitoring costs,
– Bonding costs,
– Structuring compensation costs.
• Market forces, such as the potential for hostile
takeover provide some deterrence.
• Legal forces, fraud, and fiduciary misconduct laws
aim to act as deterrents as well.
© 2004 Pearson
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28. Current View on Incentive Plans
• Executive compensation packages generally
include incentive plans that grant stock
options, performance based shares, or cash
bonuses upon meeting or exceeding
corporate goals.
• Such packages may also include long-term
benefits that can protect the manager
against poor corporate performance.
© 2004 Pearson
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29. Overview of Text
Part 1: Introduction to Managerial Finance
Part 2: Financial Analysis and Planning
Part 3: Important Financial Concepts
Part 4: Long-Term Financing Decisions
Part 5: Long-Term Investment Decisions
Part 6: Working Capital Management
Part 7: Special Topics in Managerial Finance
© 2004 Pearson
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